An index is a way to measure the performance of a particular group of assets within the stock market. There are several indexes within the market, with one of the most common stock indexes within the United States being the S&P 500. Investors use a particular index as a benchmark for the overall performance of the market.
How Does an Index Work?
Universally, an index is used to measure something. In the finance world, an index is essentially the same thing, using numbers and statistics to measure movements within the stock market. Depending on what market you are looking at, each index has its own way to calculate what is happening.
Let’s look at a hypothetical example to get an idea of how an index works. Let’s say that we’re watching the price of paper. Currently, the price of paper is $1.00/bundle with the starting index value being 1. Now let’s say the price of paper increased to $1.25/bundle. Our index would increase to 1.25 to reflect a 25% increase in the price of paper. Now let’s say the price decreases to $1.15/bundle. The $0.10 change would reflect a 10% decrease in the price of paper.
If you worked in paper sales, you would find this paper index very useful. This index would provide the proper data you needed to get an idea of what is happening with your competitors.
Why Are Indexes Important?
Indexes are important because they can measure several different aspects within the market. These aspects can include interest rates or inflation. They can measure the performance of a group of assets, securities or bonds depending on what you’re looking to invest in. Essentially, indexes try to replicate what the market is going to do. This can not only save on cost, but also make for less time consuming investing.
Types of Indexes
There are many types of indexes throughout the financial world. Several of these include price-weighted indexes, value-weighted indexes, and unweighted indexes. Below, we’ll go into detail regarding what each one of these entails.
A price-weight index is an index in which each company’s stock is weighted by its price per share. The index is then an average of all of the company’s share prices. This means that if a company has a high share price, they hold greater weight than a company with a lower share price. An example of a price-weighted index is the Dow Jones Industrial Average (DJIA).
Also referred to as capitalization-weighted indexes, a value-weighted index is one of the most common types of stock market indexes. It is a type of index that uses individual components that are weighted in regards to a company’s market capitalization. To calculate a company’s market capitalization, you would multiply their outstanding shares by the current stock price. An example of a value-weighted index is the NASDAQ.
An unweighted index is simply an index that includes components with an equal weight across the index. This means that all stocks within this index have the same impact on the price of the index. An example of an unweighted index would be the S&P 500 Equal Weight Index (EWI), not to be confused with the S&P 500.
Examples of Indexes
Let’s review some of the most common indexes within the market, including the S&P 500, Dow Jones Industrial Average, NASDAQ, and Cboe Volatility Index (VIX).
As mentioned above, the S&P 500 is one of the most common indexes in the United States. The S&P 500 tracks the market of 500 of the largest companies traded within the United States. It is a value-weighted index, meaning a company with shares worth $100 million is weighted more heavily than a company worth $50 million.
Dow Jones Industrial Average
The Dow Jones Industrial Average is a price weighted index that tracks 30 of the largest companies within the U.S. The companies represented within this index are from different industries. The companies that have higher priced stocks will have more of an impact on the index than companies with lower priced stocks.
As one of the most followed indexes within the United States, the NASDAQ index includes almost all of the stocks listed within the NASDAQ stock exchange. It is a value-weighted index, or capitalization-weighted index in nature. There are over 2,500 stocks within this index with a heavy focus on technology-related companies.
Cboe Volatility Index (VIX)
The Cboe Volatility Index (VIX), or the Chicago Board Options Exchange Volatility Index, is an index that measures the market’s expectations over the next 30 days. It’s objective is to project patterns of future volatility to assist investors with their investment decisions.
Benefits and Disadvantages of Indexes
As with most things within the financial world, there are benefits and disadvantages to using indexes when looking to invest. Let’s take a look at both the benefits and disadvantages of indexes below.
Benefits to using indexes can include:
- Easy to track: Indexes provide one measurement to follow and can be easy to gauge the performance of a particular market.
- Less likely to change much or often: Meaning, past data can provide somewhat of an idea as to what will happen in certain situations within the market.
- Less risk involved: Managers of index funds primarily seek to buy and hold securities that match the index, instead of trying to beat it, which comes with less risk.
- Lower costs: because index funds are managed on a more passive level, there are less costs associated with managing them.
Of course, there are disadvantages to using indexes when investing. These can include:
- Issues with calculation: For example, price-weighted indexes do not take into account the size of the industry or the market capitalization of a company. Also, each market is calculated differently.
- Low flexibility: Because index funds are managed passively, there is no flexibility with buying or selling securities, as they are managed based on the market.
- Errors when tracking: It is crucial to properly track the benchmarks of whatever index you are following, as this can affect your return on investment if not done properly.
- Possibility of lower returns: Again, because index funds are passively managed, they can provide lower returns than funds that are actively managed.
Using Indexes For Your Investments
Tracking a particular index can be somewhat challenging if you do not understand the ins and outs of indexes. However, they can often be associated with lower costs due to their ability to be passively managed.
If you are unsure of what direction to go when it comes to using a particular index for your investments, you can always consult a financial advisor. Financial advisors will be able to help guide you with understanding indexes. They can also help you to manage your investments within index funds.